19 Aug Investment Risk Management

Investment Risk Management

To manage risk, we recommend using five techniques:

1. Risk Reward Management:

• Risk reward management is about ensuring that your winners – on average – far outweigh your losses. As a general guideline, you should always shoot for a 1:2 risk reward ratio. That means, your potential reward should be at least double that of the potential risk to the downside. So even if you’re wrong most of the time, you can still be profitable. For example, if you’re wrong on 100 trades 65% of the time and lose $1,000 on average, you would lose $65,000 (65 losing trades x -$1,000 loss = $65,000). However, if you gained $2,000 on average on your winners, you would still have a $5,000 profit at the end of the day (35 winning trades x $2,000 gain = $70,000). As you improve your win rate percentage or your risk reward ratio, you increase your bottom-line profitability.

2. Position Sizing:

• Depending on your risk tolerance, you should not be able to lose more than 0.5% to 2% of your total portfolio value in any single position. So even if you have 10 bad trades in a row, you wouldn’t wipe out your entire portfolio and live to fight another day with the money remaining in your portfolio. For example, if you have $100,000 in total in your portfolio you would not want to lose more 2% (= $2,000) in a single trade. Your initial stop placement sets the base case loss, but also keep in mind that a stock can gap down way below your stop placement, so you can actually lose more money than originally planned. To this end, analyze the average volatility of a stock and also some of the worst days a stock has had, e.g. after a bad news announcement, to understand how well it reacts to the news. That should give you a sense of a potential worst-case scenario, if the stock were to gap down on surprisingly bad news.
• Another way to size your position is to take the same amount, e.g. 10% of your portfolio, all the time. Though this technique does not consider the amount at risk, because stop placement and the riskiness of a stock might not be the same across all of your investments. For example, on a small cap stock with high volatility, you might need a wide 20% stop below the entry price, exposing yourself to a $2,000 loss. In the case of a big cap stock with medium volatility, you might not need as wide a stop and settle for a 5% downside. In this case, you might be able to take a four times larger position in the big cap stock than in the small cap stock to balance risk.

3. Stop Management:

• There are several schools of thought on stop management:
• One way is to allow a stock to pullback to the next 1, 2 or even 3 areas of support before stopping out. The wider the stop, the more wiggle room you give the stock to breathe and play out. Some volatile small- and mid-cap stocks might need a more generous and wider stop than big-cap stocks. Otherwise you might get stopped out too early, only for the stock to reverse and hit a big home run. The downside of a wide stop is that you expose yourself to a bigger potential loss, if the stock turns out to be a loser. To alleviate the risk, use position sizing as mentioned above.
• An aggressive way to play stops is to place the stop just below the entry (0.5% to 2%) and not allow a stock that breaks out or reverses to re-test its entry point area. Though you should be prepared to get stopped out frequently. The upside is that you would only stay in the strongest stocks that continue their upward or downward momentum from the breakout or breakdown point.
• In any case, it is useful to adjust stops as your stock moves into the intended direction. Once a stock has comfortably become profitable, you might want to adjust your stop to the next level of support. The sooner you can move your stop to break-even, the better, of course.

4. Diversification:

• Diversification is important, because stocks in the same industry sector tend to move in tandem. In any given week, one industry might do well while another is trending down. To balance your portfolio’s risk, it can be useful to ensure your positions are in different industries.

5. Scaling:

• In some cases, you might not want to invest your full target position size at once, but scale into a trade at key areas of support and resistance.
• Scaling is also about taking profit. When a position reaches a first target profit area, start taking profits to lock in gains.